Exploring Determinants of Long-Term Interest Rates

In South Africa, long-term interest rates have often been high in real terms and relatively volatile, although they declined somewhat in recent years (Figure 13.1). This chapter attempts to show that this decline is due not only to an improved external capital market but also to the strong progress made in macroeconomic management. In particular, the implementation of policy measures, such as dismantling the forward book of the South African Reserve Bank (SARB), strengthening the fiscal position, and adopting an inflation-targeting framework has aided external sustainability as well as fiscal and inflation performance. These factors in turn have helped ease pressure on domestic interest rates. South Africa is a small open economy with a large and well-developed financial sector and a relatively open capital account (at least for nonresidents; see Chapter 8).1 For such an economy, arbitrage conditions would imply that the level of long-term domestic interest rates are determined by several factors, namely the foreign interest rate, the default risk premium, the currency premium, as well as the effects of remaining capital controls and other effects of imperfect asset substitution. While foreign interest rates (say U.S. rates on government bonds) constitute a benchmark for risk-free investment, country risk premium can be proxied by sovereign spreads, which mainly capture the perceived risk of South Africa defaulting on its debt (the spreads may also reflect liquidity